July 7 (Bloomberg) -- Federal Reserve Chair Janet Yellen
faces an economy that is starting to look more like Arthur
Burns’s in the 1970s than Alan Greenspan’s in the 1990s.

Productivity growth is slowing, just as it was when Burns
headed the central bank, not accelerating as it did under
Greenspan’s watch. Business output per hour excluding
agriculture has risen at a 1.4 percent average annual rate since
the recession ended in June 2009 as hiring has picked up while
economic growth has lagged behind.

That result is in line with the 1.5 percent rate from 1973
to 1977 and less half of the 3 percent pace from 1996 to 2000,
Labor Department data show. The post World War II average is 2.3
percent.

To understand why this is important, look at what happened
to the U.S. in each of those periods.

In the late 1990s, increased worker efficiency allowed
Greenspan to countenance a fall in the unemployment rate to a
30-year low of 3.8 percent in April 2000 as companies could pay
employees more without having to raise prices. In the 1970s, a
sudden downshift in productivity growth caught Burns by surprise
and led to a rise in consumer prices of more than 10 percent
after oil costs surged.

“There is a risk,” said former Fed Vice Chairman Alan
Blinder, who served under Greenspan and co-wrote a book with
Yellen about “the fabulous decade” of the 1990s. “You do have
the possibility of replaying in the same direction what happened
after 1973.”

That doesn’t mean the U.S. is about to experience a
sustained rise in inflation, he added. “We’re a long way from
seeing that.”

‘More Cautious’

What it does mean is that Yellen and her Federal Open
Market Committee colleagues must be a “little more cautious”
about keeping short-term interest rates near zero in their
pursuit of lower joblessness, said Blinder, who is now a
professor of economics at Princeton University in New Jersey.

Last month’s drop in the unemployment rate to an almost
six-year low of 6.1 percent highlights the dilemma facing the
Fed, said Stephen Stanley, chief economist at Pierpoint
Securities LLC in Stamford, Connecticut. Joblessness is falling
faster than the central bank expected while gross domestic
product is expanding more slowly than its projections. Behind
the discrepancy: slower productivity growth, according to
Stanley. He now sees the Fed starting to raise interest rates in
June 2015, instead of waiting until September of next year.

Inflation Accelerating

Inflation already is showing signs of accelerating. The
personal-consumption-expenditures price index, the Fed’s
favorite measure, rose 1.8 percent in May from a year earlier,
compared with 1.6 percent in April and 1.1 percent in March,
according to the Labor Department.

Chipotle Mexican Grill Inc. is among companies boosting
prices. “We really haven’t had any resistance” from customers,
Steve Ells, co-chief executive officer of the Denver-based
burrito chain, told Bloomberg Television’s “Surveillance” on
June 27. The increase of as much as 6 percent will partly offset
higher costs for ingredients and is Chipotle’s first in three
years.

“We are facing a problem of rising inflation,” said
Martin Feldstein, a professor at Harvard University in
Cambridge, Massachusetts, and former chairman of the White House
Council of Economic Advisers. The Fed is “probably going to
respond too weakly, too slowly,” he added in a June 4 interview
on “Surveillance.”

Higher Rates

Long-term interest rates are “going to go a lot higher,”
with the yield on the 10-year Treasury note eventually hitting 4
percent, as price pressures intensify and the Fed lags behind in
its response, according to Joe LaVorgna, chief U.S. economist at
Deutsche Bank Securities Inc. in New York. The note’s yield was
2.64 percent at 2 p.m. in New York on July 3, ahead of the July
4th U.S. holiday, based on Bloomberg Bond Trader data.

The Fed’s macroeconomic computer model recognizes that
unexpected changes in productivity growth can affect inflation,
said Michael Feroli, a former central-bank researcher who is now
chief U.S. economist for JPMorgan Chase & Co. in New York. The
question is whether policy makers will factor this into their
decisions on interest rates.

“You could have, at least in the short run, a little bit
of a policy mistake if they overestimate productivity growth,”
he said. “If they’re wrong, you’re going to see it show up in
faster inflation.”

Feroli changed his forecast of Fed policy after last week’s
news of a further fall in joblessness. He now expects the
central bank to begin raising interest rates in the third
quarter of next year, instead of the fourth.

Anemic Growth

“It’s true that the decline in unemployment is occurring
alongside anemic GDP growth, but the Fed’s mandate is not to
ensure strong productivity growth, it’s to get the economy back
to full employment and price stability,” Feroli said in a July
3 note to clients.

Fed officials have been nudging down their estimates of how
fast the economy can expand without fanning price pressures as
productivity growth has ebbed. Most FOMC participants peg the
economy’s cruising speed at 2.1 percent to 2.3 percent,
according to their June 18 projections. While that’s down from
the 2.5 percent to 2.8 percent range they saw in April 2011, it
still may be too optimistic, Feroli said. He reckons the rate is
1.75 percent, with a chance it could be even lower.

What’s important in determining the inflation outlook is
the long-term trend in productivity growth, Blinder said. That’s
not easy to figure out as the quarterly data jump around a lot.
Output per hour slumped at a 3.2 percent annual rate in the
first quarter, according to a preliminary government estimate,
after an increase of 2.3 percent in the final three months of
2013.

Measurement Errors

The recent slowdown also could reflect measurement errors,
Blinder said. Productivity is calculated based on the gross
domestic product of the economy. If it were computed using gross
domestic income, growth would be faster. GDP has risen by an
average annual rate of 2.1 percent since the recession ended,
while income has climbed at a 2.4 percent clip, according to
data from the Commerce Department.

Yellen played down the significance of the acceleration in
inflation this year, telling reporters on June 18 the advance
generally is consistent with the Fed’s forecasts.

“The recent evidence we have seen, abstracting from the
noise, suggests that we are moving back gradually over time
toward our 2 percent objective,” she said. “I see things
roughly in line with where we expected inflation to be.”

Efficiency Important

Worker efficiency is especially important because of the
emphasis Yellen has placed on the need for higher wages. If
employees are able to produce more, companies can pay them more
without needing to raise prices to keep profits up.

She told reporters she anticipates wage growth will pick up
as the labor market tightens and argued this wouldn’t be
inflationary as long as the increase isn’t overly rapid.
Compensation recently has been growing about 2 percent a year,
by Yellen’s reckoning.

Compensation increases of as much as 4 percent would be
“normal” and consistent with the Fed’s 2 percent inflation
goal, she said during a March 19 press conference. That, though,
assumes productivity growth doesn’t slacken.

Charles Plosser, president of the Federal Reserve Bank of
Philadelphia, told the Fox Business Network on June 24 that he
isn’t worried about short-term inflation. He did evince some
unease with Yellen’s emphasis on wage growth, telling reporters
separately it’s a lagging indicator of inflation.

Yellen, Plosser

Yellen agreed with Plosser back in 2008 that “wages aren’t
a leading indicator,” according to the transcript of the April
29-30 FOMC meeting that year.

Now though, she stresses there’s still a “significant”
amount of slack in the labor market that will help hold price
pressures in check even though the unemployment rate has fallen.

The risk is she might be underestimating how tight the job
market is, just as she could be overestimating productivity.

If signs continue to indicate that potential GDP growth has
fallen “a lot more than the FOMC has recognized” and there
isn’t a large remaining margin of slack in the economy, “the
Fed may face some difficult choices going forward,” Ted
Wieseman, an economist at Morgan Stanley in New York, wrote in a
June 27 note to clients.